The New Robber Barons Page 20

  An RMBS known as GSAMP-2006 S3 was among $494 million of securities bought by institutional investors in April 2006 and was created and distributed by Goldman Sachs Alternative Mortgage Products (GSAMP). Fortune's Allan Sloan and Doris Burke followed the deal as its value slid ever downward as well as the fudgy way the deal's deteriorating value seemed to be overstated by the trustee's report. “Defaults and rating downgrades began almost immediately. In July 2008, the last piece of the issue originally rated below AAA defaulted -- it stopped making interest payments. Now every month's report by the issue's trustee, Deutsche Bank, shows that the old AAAs -- now rated D by S&P and Ca by Moody's [junk ratings] -- continue to rot out…[by the end of October] only $79.6 million of mortgages were left, supporting $159.9 million of bonds...But even worse, those mortgages aren't worth anything like their $79.6 million of face value… the remaining bonds are worth maybe 10% of face value.”

  D. Raters’ Role in Violation of Securities Laws: “Investment Grade Rated” Was Junk

  Note that if you take a mezzanine (investment grade but lower rated than “AAA”) tranche of GSAMP’s previously mentioned RMBS, at the outset it has little value. In other words, “assets” such as these with “solid investment grade ratings” are nearly worthless junk. Yet mezzanine tranches such as these were routinely securitized into CDOs without disclosure that the rating labels were at the outset materially misleading.

  The Congressional subprime probe revealed that due diligence reports such as those provided by Clayton Holdings Inc. showed grave problems with the original loans, yet these reports were either ignored or suppressed and this material information was not disclosed in deal documents when securities were sold.

  Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities. Underwriters are responsible for appropriate due diligence, an investigation into the risks. If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed. Even sophisticated investors can be victims of fraud if they performed adequate due diligence and difficult-to-uncover material facts were withheld.

  Rating agencies cannot competently rate securities without someone performing due diligence on the underlying collateral, and raters have to thoroughly examine it. Multi-year problems in the mortgage loan market combined with risky new products and lower underwriting standards were waving red flags. Although the rating agencies are not responsible for performing due diligence, under any professional standard they are required to review evidence of appropriate due diligence, and the bar for the definition of “appropriate” becomes higher in the face of more red flags.

  In other words, it appears the rating agencies’ enabled the sale of mislabeled securities either through willful negligence or technical incompetence. Either way, the rating agencies do not merit the NRSRO designation.

  E. Merrill Lynch’s Example of Ponzi Finance

  Merrill Lynch was a part owner of California-based Ownit Mortgage Solutions. Ownit made second-lien mortgages, issued 45-year ARMs, and originated no-income-verification loans. In the words of William D. Dallas, its founder and CEO: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.”

  Michael Blum, Merrill Lynch’s head of global asset-backed finance sat on Ownit’s board. Neither Ownit nor Merrill can claim the relationship was arm’s length. Revenue was up around 33% in the first three quarters of 2006, but Ownit was losing money. In November of 2006, JPMorgan Chase told Ownit that its $500 million credit line would disappear on December 13. Ownit went bankrupt at the end of December 2006.

  When Ownit imploded, Blum faxed in his resignation to Ownit’s Board of Directors. In this post Sarbanes-Oxley world, one might have expected Blum to insist on a thorough audit of Ownit instead of faxing in his resignation, particularly since Merrill didn’t stop securitizing Ownit’s loans. For example, Merrill brought an RMBS to market in early 2007 that included Ownit’s piggyback loans (second liens). Around 70 percent of the borrowers had not provided full documentation of either their income or assets, and most borrowers had a 100% loan to value ratio, meaning the mortgage balance was at least as great as the value of the property being mortgaged. At the time, home prices were weak and falling.

  The deal’s documents omitted the fact that Merrill was Ownit’s largest creditor. In early 2008, the “AAA” tranche was downgraded to junk. Moody’s forecast that the original portfolio could lose around 60 percent of its value. In other words, the permanent value destruction of principal would be around 60 percent. Bond Fund of America was among the burned investors.

  Instead of halting securitization activity to review loans, Merrill accelerated CDO activity in the first half of 2007. That was just a few months before private label mortgage securitization ground to halt in the U.S. JPMorgan, Ownit’s credit line provider, was no better, even if its CDO volume was lower than many other banks. For example, it is being sued for a deal called “Squared” brought to market in May 2007.

  CDOs were often offloaded on naïve investors. Funds in Europe and the United States—including local government run funds—often find they did not understand the risks of complex structured financial products they own, because they relied on the “AAA” ratings for guidance. These Main Street government investors have no choice but to cut costs, aggressively go after back taxes, and—if the problem is bad enough—raise taxes. Main Street’s list of investors that feel burned is long and growing.

  For example, the Springfield (Massachusetts) Finance Control Board alleged that Merrill Lynch & Co. sold it “AAA” rated CDO products backed by subprime debt without fully disclosing the risk. State law limits Springfield’s investments to government securities and short-term liquid investments. Regarding Springfield, I told the Wall Street Journal: “Merrill has to know its customers and sell them what’s suitable and appropriate. These CDOs are not.”

  There is often a difference between an investor with a lot of money to manage and a sophisticated investor. That is why many compliance departments at investment banks ask that brokers and institutional salespeople to “know your customer.” Investments must be “suitable and appropriate” for investors. The idea is to sell complex products to investors that have the ability to understand and analyze the risk.

  Springfield Finance Control Board was fortunate that its troubles received publicity. The “AAA” rated tranches were overrated and at the outset merited a “junk” rating. The three CDOs that Springfield originally purchased for $13.9 million in the summer of 2007 were valued by Merrill at around $1.2 million by January 2008. In the wake of negative publicity, Merrill repurchased the CDOs for the full amount of $13.9 million.

  F. Merrill Lynch: Signs of A Classic Control Fraud

  Through a variety of tricks and gimmicks, Merrill tried to hide risk that couldn’t be offloaded on unwary investors in a desperate game to avoid taking substantial accounting write downs in the first half of 2007. This presents all the earmarks of a classic control fraud. I reviewed all 30 of Merrill’s ABS CDOs brought to market in 2007 representing a notional amount of $32 billion. Without exception, all of them presented a classic situation for fraud. By June 10, 2008, all 30 had one or more “AAA” tranches downgraded to junk by one or more rating agencies. (APPENDIX X.)

  Among the CDOs were multi-sector CDOs with a lot of mezzanine CDOs from other failing deals. When Merrill couldn’t find investors, it stuffed junk into new CDOs to hid losses by creating an artificial “bid” and covering the problematic tranches with phony investment grade ratings on new tranches. Merrill also issued CDO-squared products. One example is a CDO-squared called Durant issued in June 2007. Its portfolio consisted almost entirely of credit default swaps referencing mezzanine tranches of other very problematic CDOs with a couple of mezzanine CLO tranches and subprime home equity loan tranches thrown in. This entire CDO was a piece of junk right from the start
. I am not just making these comments today, I made them publicly and ongoing before these phony deals came to market.

  Six months later, in January 2008, Durant was in liquidation. (APPENDICES X. and XI.)

  Rating agencies and the SEC had no excuse for allowing deals like this to come to market (or appear to come to market, since Merrill also retained a lot of cynically repackaged and misrated risk, another characteristic of control fraud), particularly in 2007 when it was obvious mortgage lenders were imploding. In an article for Risk Professional (then called GARP Risk Review) at the beginning of 2007, I specifically mentioned Merrill’s securitization activity and that risk managers should get out before they become scapegoats. These problems were known, but by allowing securitization activity like this to continue, the rating agencies and the SEC enabled a cover-up of accounting losses through the issuance of phony securitizations.

  G. Monoline Insurers

  Throughout 2006-2008, the situation of the financial guarantors was much more desperate than the ratings reflected. The largest U.S. municipal bond insurers (called monolines even though they dabbled in other areas), Ambac and MBIA were still rated “AAA” in January 2008. The rating agencies expressed concern, but they performed ludicrous stress tests using insufficient default scenarios and recovery values that were much too high. I released a rebuttal. On the basis of projected loan losses alone, monolines were undercapitalized and did not merit an “AAA” rating. Although the insurance companies and the rating agencies denied it at the time, it was clear they would experience significant principal losses.

  Once again, I was at odds with the slow response time and artificially high ratings of the rating agencies. As I noted in my report at the time, the situation was much worse than losses due to the fraud riddled loans. The CDOs also had stunning financial engineering risk. The monolines had insured CDOs and some late vintage multi-sector CDOs that were particularly ugly. MBIA had insured some of Merrill’s 2007 CDOs. The deals had enormous “cliff” risk from near worthless collateral used in the original portfolios. The rating agencies seemed to ignore this or perhaps they didn’t understand it.

  APPENDIX XII shows problematic CDOs insured by Ambac and MBIA, the largest bond insurers—but not the only bond insures to implode after being misrated—and lists the underwriters and so-called managers of those deals. The deals are shown to be contemporaneous with my challenge of the rating agencies’ analysis. Based on their public statements, the rating agencies seemed incompetent. There is a possibility that they understood the problem and lied to prevent a public panic, but if so, they were very good at covering up any hidden expertise. Ambac and MBIA subsequently imploded. Ambac and MBIA later negotiated discounted settlements for many of these CDOs and some of the deals are in the midst of legal disputes.

  H. Rating Agencies’ Misrepresentations Throughout 2007 and Beyond

  In the face of trenchant criticism, the rating agencies continued to make excuses for their poor performance, saying the overwhelming majority of ratings actions (downgrades and declarations of events of default) had been directed at the weakest-quality subprime securities. They pointed out that few “AAA” tranches had been downgraded (by them).

  The rating agencies claimed that “AAA” tranches were unlikely to experience a loss. This was laughable misdirection by the rating agencies. SIV-lite debt (SIV-lites invested in “AAA” CDOs) was subsequently downgraded to CCC from “AAA” almost overnight. “AAA”s from CPDOs, ABCP, CDOs, and CDO-Squareds, were downgraded to junk.

  The rating agencies' assertion at the time that it doesn't matter much if only BBB-rated and lower tranches are downgraded was also misdirection. In the past, when BBB and below tranches were downgraded, “AAA” tranches were not downgraded because the deals were usually older deals and the higher-rated tranches were largely amortized with only a small principal balance remaining. There was very little risk to the higher-rated tranches. But many of the subprime-backed deals that had been downgraded were recent 2006–2007 vintages. More than 300 tranches of these new securitizations were placed on downgrade or negative watch by the rating agencies. No reasonable financial professional accepted that the “AAA” tranches of such deals were as creditworthy as the previous “AAA” tranches of non-mortgage and non-leveraged loan deals in which the lower tranches had not been downgraded.

  If this were not bad enough, liquidity dried up due to oversupply of misrated product and too little demand for hard-to-value securities. The market not only penalized CDOs with wider credit spreads to account for the greater credit risk, but also penalized these tranches for their opacity. Prices decoupled from fundamental value causing even further price drops. The rating agencies assert that the entire price drop was due to lack of demand and illiquidity, but the cause of the lack of demand was the fact that many structured products were incorrectly rated at creation.

  In other words, either through intention or incompetence the rating agencies lied in the sense that they made false statements that had grave consequences for investors and the global financial markets.

  VII. SOVEREIGN RATINGS

  Sovereigns that bailed out banks are saddled with much greater government debt than before the crisis. In the spring of 2007, the Fed and the U.K.’s FSA reported that the degree of leverage in the global financial system was less than at the time of Long Term Capital Management, but in reality it was much greater. Global regulators are now repeating their mistakes. The risks in the interconnected global banking system have moved to currency trading and currency derivatives (remember the contribution of knock-in options to the 1995 currency crisis), leveraged loans, credit derivatives, market-linked derivatives, speculation in commodities, and both foreign and domestic government debt. Winston Churchill said we must alert somnolent authority to novel dangers; but our regulators are complacent, and the dangers are not novel.

  With respect to the recent crisis, highly leveraged fixed income assets posed perils to the global banking system. When excessive leverage is combined with fixed income assets acquired at par, there is extreme risk. If the assets decline in value and liquidity becomes tight, it can cause a vicious cycle of selling that feeds on itself. If one combines that with foreign currency risk, one adds to the potential pain. If that is further accompanied by a price reduction that is due to a permanent or at least sustained price decline in underlying assets, it is virtually impossible for an undercapitalized overleveraged entity to recover from even a temporary liquidity shock. If a country cannot quickly refinance (roll financing), the collapse is quick and brutal. This isn’t a new discovery, this is simply a fact.

  The structured component of international finance is so influential that the failure of the rating agencies to competently rate structured financial products—and their overall incompetence with derivatives—means that their sovereign ratings are largely meaningless. The various issues with Portugal, Ireland, Italy, Greece and Spain (the PIIGS) are beyond the scope of this report, but the rating agencies, already at sea, seem to be somewhat influenced by politics as downgrades lagged and in some cases continue to lag reality. The result is that ratings adjustments come long after the need for a downgrade is obvious. To be clear, this has nothing to do with the theory of efficient markets. The rating agencies seem to flounder and arrive late to the party.

  Banks that engaged in leveraged borrowing and that trade derivatives including currency derivatives, credit derivatives, commodity derivatives, and interest rate derivatives are not within the ability of the rating agencies to competently rate. Since Governments’ and Central Banks’ finances are intimately tied with the global banking system, the rating agencies do not competently rate sovereign debt.

  A. Sovereign Rating Example: Iceland’s “Aaa”

  Moody’s misguided “Aaa” ratings were not limited to securitizations. In 2007, financial professionals derided Iceland’s inflated “Aaa” rating due to the risk posed by excessive leverage and excessive borrowing in foreign currencies. A cult YouTube vid
eo, apparently out of Bombay, India in 2007 mocked Moody’s and its “Aaa” Iceland rating. It was widely circulated among financial professionals.

  Moody’s tried to temper its decision in a January 2008 report: “Iceland’s Aaa Ratings at a Crossroads.” It wrote: "Iceland enjoys high per capita incomes, well-developed political, economic and social institutions, favorable demographics and a fully-funded public pension system…Its government debt ratio is less than half the average of the Eurozone member countries.” Moody’s did all it could to rationalize its decision to maintain the “Aaa” rating.

  As was true of many of Moody’s “Aaa” ratings, it was forced to give up the game. In October 2008, Iceland temporarily suspended stock trading and seized Kaupthing, the country’s largest bank, as its banking system collapsed and plunged the country into bankruptcy. Iceland’s external debt was around $70 billion at current exchange rates (then €50 billion) or around $218,000 for each of its 320,000 citizens.

  B. United States: “AAA” in Label Only

  The financial debacle was enabled by a classic control fraud within our largest banks. Wall Street’s huge bonus payments were based on suspect accounting, and bankers continue to seek those rewards by ramping up risk within the banks. Many banks’ current illusion of profitability is currently only made possible by taxpayers’ enormous subsidies including low cost borrowing, higher interest payments on bank capital deposits, a credit line for the FDIC (to be repaid with banks’ subsidized profits), and continued government debt guarantees on bank debt. A large share of certain banks’ tax-subsidized profits is due as reparation to unsophisticated investors, the U.S. taxpayers. While the Fed prints money, it seeks to keep short-term interest rates artificially low, essentially robbing investors who earn such low interest rates on “safe” investments, that after inflation, they are earning negative real returns.